Behavioural Economics Exam Review Flashcards

Practice flashcards covering core concepts in Behavioural Economics (ECO 414), including Expected Utility Theory, Prospect Theory, framing effects, mental accounting, overconfidence, heuristics, and development economics applications.

What is behavioural economics

asks what happens when we replace the Econ with a real, psychologically realistic decision maker(Human)? It integrates findings from psychology into economic models of judgment, choice, and welfare

What are the core characteristics of System 1 and System 2 in Dual-Process Theory?

System 1 is fast, automatic, subconscious, emotional, and low-effort, while System 2 is slow, deliberative, conscious, logical, and high-effort.

How is choice under risk modeled in Von Neumann–Morgenstern Expected Utility Theory (EUT)?

In EUT, an Econ ranks lotteries based on expected utility E[u(W)] = \begin{sum}_i p_i u(W_i)\begin{end}, where $W$ represents final wealth states.

Which axiom of Expected Utility Theory states that preferences between two lotteries are unaffected by mixing both with a common third option?

The independence axiom, which empirical evidence by Allais ($1953$) showed is systematically violated by real human choices.

How does Expected Utility Theory represent diminishing marginal utility on a utility curve?

Expected Utility Theory represents diminishing marginal utility through a concave utility function $u(W)$, where equal gains in wealth \begin{Delta} W\begin{end} yield smaller utility increments (\begin{Delta} u_1 > \begin{Delta} u_2\begin{end}).

Who authored Prospect Theory in $1979$, and in which journal was it published?

Daniel Kahneman and Amos Tversky authored Prospect Theory, published in Econometrica in $1979$.

What are the two foundational departures of Prospect Theory from Expected Utility Theory?

The two core departures are reference dependence (evaluating outcomes as gains and losses relative to a reference point) and loss aversion combined with diminishing sensitivity.

According to Prospect Theory, how do gains and losses differ in shape, risk attitude, and slope near $0$?

For gains, the value function shape is concave, risk attitude is risk averse, and slope near $0$ is moderate; for losses, the shape is convex, risk attitude is risk seeking, and slope near $0$ is steep (roughly 2-2.25\begin{times}\begin{end} the gain slope).

What are the structural features of Prospect Theory's S-shaped value function curve?

The S-shaped curve passes through the origin (the reference point), remaining concave above the origin for gains $v(100)$ and convex and much steeper below the origin for losses $v(-100)$.

What numerical ratio reflects the psychological asymmetry of loss aversion in Prospect Theory?

Losing $100$ dollars hurts roughly $2$ to $2.25$ times as much as gaining $100$ dollars feels good.

In the Asian disease problem by Tversky and Kahneman ($1981$), how were the two choice frames structured for $600$ total people?

Group $1$ received a gain frame (Program A: $200$ saved; Program B: \begin{frac}{1}{3}\begin{end} probability $600$ saved, \begin{frac}{2}{3}\begin{end} probability $0$ saved), while Group $2$ received a loss frame (Program C: $400$ die; Program D: \begin{frac}{1}{3}\begin{end} probability $0$ die, \begin{frac}{2}{3}\begin{end} probability $600$ die).

Why do decision-makers reverse their choices between Program A and Program D in the Asian disease experiment?

Decision-makers are risk averse in the gain frame (choosing sure option A) and risk seeking in the loss frame (choosing gamble D to avoid sure loss C), consistent with Prospect Theory's S-shaped value function.

What is mental accounting as conceptualized by Richard Thaler?

Mental accounting is the psychological tendency to sort money into non-fungible separate mental 'buckets' or budgets, leading to decisions that violate financial fungibility.

What were the results of the theatre-ticket experiment by Heath and Soll?

Individuals who had spent $50$ dollars on a basketball game were significantly less likely to buy a $50$ dollar theatre ticket than those who paid a $50$ dollar parking ticket, because the game and theatre ticket shared the same 'entertainment' account.

How did household spending behavior following the $2008$ gasoline price drop illustrate mental accounting?

Hastings and Shapiro ($2013$) found households upgraded to premium gasoline about $14$ times more than standard income effects predicted, spending within a dedicated 'gas budget' account without similar upgrades for milk or orange juice.

What is the 'house money' effect in behavioral finance and gambling?

The 'house money' effect describes the tendency for individuals to take greater risks with money categorized as prior winnings ('the casino's money') compared to their own initial capital.

How is the planning fallacy defined by Daniel Kahneman?

The planning fallacy is the tendency to make forecasts unrealistically close to best-case scenarios by relying on an inside view while ignoring baseline statistical data from similar past cases.

In Kahneman's curriculum project case study, what was the contrast between the team's initial estimate and the expert's outside view?

The team estimated completion in $2$ years (inside view), whereas the expert's outside view revealed 40\begin{percent}\begin{end} of similar teams never finished and successful ones took $7$ to $10$ years (actual completion took $8$ years).

What is the distinction between the inside view and the outside view in project planning?

The inside view focuses on specific project details and plans, whereas the outside view evaluates historical statistics and outcome base rates from a reference class of similar past projects.

What causes the 'illusion of validity' among decision experts?

Subjective confidence in judgments depends on the narrative coherence of the story experts construct, rather than its true predictive accuracy.

What is the index-insurance puzzle observed in agricultural development across Africa and South Asia?

Risk-averse smallholder farmers exhibit demand for rainfall index insurance far below expected-utility theory predictions, even when policies are subsidized.

What three behavioral mechanisms explain low adoption rates of rainfall index insurance among farmers?

Ambiguity aversion regarding probability estimates, basis risk and lack of trust in payout mechanisms, and present bias regarding the timing of premium payments.

In Bayesian updating, how does confirmation bias distort judgment relative to Bayes' Rule P(\begin{text}{θ}\begin{end} | E) \begin{propto}\begin{end} P(E | \begin{text}{θ}\begin{end}) P(\begin{text}{θ}\begin{end})?

Confirmation bias leads individuals to overweight likelihood values P(E | \begin{text}{θ}\begin{end}) for evidence $E$ that confirms their prior belief \begin{text}{θ}\begin{end}, while discounting conflicting evidence.

What probabilistic rule does the Linda Problem violate when people demonstrate the conjunction fallacy?

It violates the rule P(a \begin{text}{ and }\begin{end} b) \begin{le}\begin{end} P(a), as individuals rate the joint probability of two events higher than the probability of a single constituent event.

What is the anchoring and adjustment heuristic?

A cognitive process where estimates begin at an initial reference point ('anchor') and adjust insufficiently toward the target quantity.

How does the availability heuristic influence risk assessment?

Individuals judge the frequency or likelihood of an event based on how easily specific instances or examples can be retrieved from memory.

What is the representativeness heuristic?

A decision rule where the probability that an item belongs to a specific category is evaluated by how closely it resembles the prototype of that category.

What is status quo bias and how does loss aversion cause it?

Status quo bias is a preference for maintaining the current state, driven by loss aversion because potential losses from changing baseline conditions weigh more heavily than prospective gains.

What is the endowment effect?

The phenomenon where individuals place a higher value on an object simply because they own it, creating a discrepancy between selling price and willingness to pay.

How does hyperbolic discounting differ from standard exponential discounting in time preferences?

Hyperbolic discounting introduces present bias with disproportionately high impatience for immediate trade-offs compared to future trade-offs, leading to time-inconsistent preference reversals.